Like countless others, I read Benjamin Graham's book The Intelligent Investor when I was young. It totally changed how I looked at investing.
Graham's book was more than theory. He gave directions -- actual formulas -- investors could use to find cheap stocks. The formulas were simple and they made sense. This appealed to me, as I had no idea what I was doing.
But something became clear once I started putting his formulas to use. None of them worked.
Graham advocated purchasing stocks trading for less than their net working assets -- basically cash in the bank minus all debts. This sounded great, but no stocks actually trade that cheaply anymore -- other than, say, a Chinese pharmaceutical company accused of accounting fraud, or a shell company run out of a garage in Toledo. No thanks.
One of Graham's criteria suggested that defensive investors should avoid stocks trading for more than 1.5 times book value. Following this rule in recent years would have led an investor to own almost nothing but banks and insurance stocks. In no world is this possibly OK.
The Intelligent Investor is one of the greatest investing books of all time. But I don't know a single person who has invested successfully implementing Graham's formulas exactly as they're printed. The book is chock-full of wisdom -- more than any other investment book ever published. But as a how-to guide, success is elusive.
This bothered me for years. Then, a year ago, I had lunch with Wall Street journalist Jason Zweig, who explained what was happening.
Graham was as practical as he was brilliant. This is probably because in addition to being an academic he was an actual money manager, running what we'd now call a hedge fund. He had no desire to stick with antiquated strategies that other investors had caught on to and become too competitive, rendering them less effective.
"In each revised edition of The Intelligent Investor," Zweig once wrote, "Graham discarded the formulas he presented in the previous edition and replaced them with new ones, declaring, in a sense, 'that those do not work any more, or they do not work as well as they used to; these are the formulas that seem to work better now."
The most recent edition of The Intelligent Investor was published 42 years ago. Who knows what Graham's strategies would look like today if he were alive to update them?
The cornerstones of successful investing are timeless. Patience, contrarian thinking, and tax efficiency will be as important 50 years from now as they were 50 years ago.
But among specific investing strategies, things change.
Every strategy to outperform the market must be based on the logic of, "The market disagrees with me today, but it will agree with me in the future, and when it does share prices will rise and I'll profit." But what investors believe today, and what they're likely to believe tomorrow, changes. Since the prevalence of data, social norms, and company disclosures change over time, what worked in one era might not work in another. As an investor, you have to adapt.
Just before his death in 1976, Graham was asked whether detailed analysis of individual stocks -- the kind of stuff he became famous for -- was still a strategy he believed in. He answered:
In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then.
What he believed, he continued, was buying a portfolio of stocks based on a few criteria -- maybe low P/E ratios, or high dividend yields. But what matters -- and what so many overlook when studying Graham -- was that he changed his mind. He adapted.
In his great book Investing, Robert Hagstrom compares financial markets to biological evolution. There's a tendency to think of markets as something that are established and rigid -- a set of numbers that get jumbled around. But they're not. Markets evolve over time. Successful strategies are selected, while those that are no longer effective -- usually because investors gain access to better information than they had before -- get pushed out.
Hagstrom looked at the last 100 years, and found that four popular investing strategies have come and gone.
"In the 1930s and 1940s, the discount-to-hard-book-value strategy ... was dominant. After World War II and into the 1950s, the second major strategy that dominated finance was the dividend model ... By the 1960s ... investors exchanged stocks paying high dividends for companies expected to grow earnings. By the 1980s a fourth strategy took over. Investors began to favor cash-flow models over earnings models. Today ... it appears that a fifth strategy is emerging: cash return on invested capital."
If you don't know that markets have evolved and some strategies are no longer valid, you'll end up making terrible decisions.
"If you are still picking stocks using a discount-to-hard-book-value model or relying on dividend models to tell you when the stock market is over or under-valued, it is unlikely you have enjoyed even average investment returns," Hagstrom writes. There is no reason to expect this strategy will lead to outperformance because so few investors pay attention to it anymore. Even if you find stocks trading at a discount to book value, there's no reason to believe that anyone else will agree with you ... later.
So many investors today put tremendous faith in investing metrics showing, say, that this stock is overvalued, or that the overall market is undervalued. They back it up with a century worth of historic data, showing how well the metric has worked in the past.
I often wonder: Have things changed? Have so many people caught onto a popular metric that they're less effective than they were in the past? Should we, like Graham, be constantly tinkering with our metrics, discarding what's unlikely to work anymore?
The S&P 500 did not include financial stocks until 1976; today, financials make up 16% of the index. Technology stocks were virtually nonexistent 50 years ago. Today, they're almost one-fifth of the index. Accounting rules have changed over time. So have disclosures, auditing, and market liquidity. 401(k)s and IRAs -- which hold trillions of dollars --- didn't exist until 40 years ago. Comparing today's market to the past isn't apples to apples.
There's a mocking statement that "it's different this time" are the four most costly words in investing. And sure, investors fall for some of the same traps again and again. But for many things, it's always different this time. Things change. So should you.